Officially speaking, the U.S. economy is not in a recession, but hardly a day goes by without some mention of the word “recession.” Most economists are predicting one, corporate management teams are preparing for one, and even the minutes from the Federal Reserve’s March Federal Open Market Committee meeting include a projection that the U.S. economy will enter one later this year. In fact, fear of an impending recession has been hashed out for more than 18 months now. The reasons are myriad, be it the inversion of the yield curve, the unprecedented speed at which the Federal Reserve has been raising rates, or ongoing geopolitical uncertainty. What you do not hear much about in these uncertain days, however, is what shape a recovery would take and how investors should position themselves.

From our perspective, the likelihood of a recession seems to have been growing of late and has certainly been well telegraphed, with certain observers having promised one for at least the last year. We think these warnings of widespread demand destruction have given well-managed companies ample lead time to prepare while also allowing for the lion’s share of the negative economic news to have been priced in to select small caps. At the end of the April, the average stock in the Russell 2000 Index was down -35.3% from its 52-week high. While the catalyst for a recovery is, like so much else, not clear now, one will eventually emerge, and we think investors should start positioning themselves accordingly. Related to this is the fact that small cap’s historical performance patterns show that below-average longer-term return periods have been followed by above-average longer-term return periods.

When five-year annualized returns for small caps are 5% or less, as they are as of this writing, history has shown that subsequent annualized three-year returns have been positive 100% of the time—that is, in all 84 three-year annualized periods— and averaged 17.7%, which was well above its monthly rolling average three-year return of 9.8% since the Russell 2000’s 12/31/78 inception.

The small-cap index also enjoyed positive annualized five-year returns 100% of the time—that is, in all 81 five-year periods—following five-year periods when annualized returns were 5% or lower. In fact, the Russell 2000 averaged an impressive five-year return of 14.9%, well above its monthly rolling five-year return since inception of 9.6%. In this context, it’s worth noting that the average annualized five-year return for the Russell 2000 was 3.2% as of 5/9/23 and 4.7% for the five years ended 3/31/23.

Subsequent Average Annualized 3- and 5-Year Performance for the Russell 2000 Following 5-Year Annualized Return Ranges of Less Than 5%
From 12/31/83 through 4/30/23

Past performance is no guarantee of future results.

Given the constant short-term focus of the markets today, it can be difficult to look out three to five years to an environment where the economy and markets are likely to be growing again. We believe the small-cap environment is replete with opportunities, with what we think are attractive valuations in many cases. So, while the near-term view remains cloudy, and recession remains a possibility, its length and severity are unknowable. In addition, the small-cap market appears to have largely discounted this outcome. We also know that any recession, like any bear market, is ultimately finite and will in all probability be succeeded by a recovery. While the catalyst for a recovery is equally unknowable, we continue to patiently use this volatile market to position our portfolios for the recovery that will undoubtedly come.

Stayed tuned…

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